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by InnReg

Fintechs Must Consider Regulatory Scrutiny

Categories: Compliance Risk


Regulatory scrutiny considerations for fintechs are likely to increase in 2021 and beyond. Disruptive innovators in blockchain and digital assets can help stay on the right side of current and future trends if they do not skip steps as they plan for growth. Mapping out the grey areas in advance and building a sustainable regulatory strategy will help keep newer disruptors in the black and out of the headlines.


An Existential Question for Regulated Entity

One of the most common questions startups struggle with is whether they must register or get licensed as a regulated entity. Fintech-driven investment advisors ask about SEC requirements, broker-dealers ask about the SEC and FINRA, money transmitters and lenders ask about federal and state regulatory requirements. The answers to this question determine who they are and who they can be in the future as they grow.


Exemptions Can Be Limitations for Regulated Entity

In many cases, registering or getting licensed as a regulated entity is not technically required. Many fintechs meet the criteria for exemptions. But in choosing not to become regulated, companies can also potentially seal their fate; they lock themselves into a certain size or business model. Their early-stage decision becomes a limiting factor to growth, inhibiting rapid client acquisition or shutting out future revenue streams.


Regulatory Scrutiny and Grey Areas

Worse, fintechs risk slipping into grey areas. They may conduct activities that attract the attention of regulators. It can be very easy for a firm to cross the line from offering a platform that enables certain activities to conducting those activities in a way that falls under regulation, such as providing investment advice or trading equities. While these unlock new revenue streams, they also raise new questions.

In these types of scenarios, companies who chose not to register or get licensed may also not have built a robust compliance and audit function within their business because it did not seem necessary. As a result, as they pursue ways to grow, they begin facing scrutiny that they do not have the resources to handle.


BitMEX: A Case in Point

Recent high-profile action against BitMEX highlights many of these points. The Department of Justice charged key executives with violating the federal Bank Secrecy Act by failing to register as a futures commissions merchant (FCM) while serving U.S. customers. The indictment charges BitMEX with violating the Bank Secrecy Act and not implementing Anti-Money Laundering (AML) and Know Your Customer (KYC) compliance programs. In response, BitMEX had to ramp up a rapid customer verification program for existing accounts.

BitMEX can serve as an object lesson for other companies. You do not have to scramble to catch up to requirements after an indictment. Instead, you can take a proactive approach that includes registering, building compliant business functions, and adopting measures to comply with regulatory requirements. Even if you are not sure that such requirements apply to you, they add a layer of proactive risk management to the way you run your business.


Four Ways to Build a Proactive Regulatory Strategy

By developing a regulatory strategy proactively and early in its development, a company mitigates risks and builds flexibility for growth. It also has an easier path towards building a compliance function as required by regulation.

Fintechs can draw the following four lessons from BitMEX:

Make regulatory strategy an integral component of business planning.

Regulatory strategy must not be an afterthought. Be explicit about the ties between business strategy, revenue streams, and the regulatory bodies that govern business activities.

Start with the end in mind.

Since regulation goes hand in hand with compliance, planning for regulation means a detailed understanding of the required people and processes. Running a supervision and compliance program can require managing hundreds of tasks across multiple functional areas. Fintechs cannot become regulated entities without demonstrating their ability to operate compliantly.

Rely on legal and compliance experts with extensive fintech experience.

Most regulations for financial and trading activity were developed before fintech existed. It can be challenging to develop a clear picture of how they apply. Working with attorneys who have experience interpreting financial regulation for fintechs and with compliance professionals who understand digital disruption helps close the gaps.

Get creative about staffing.

Few early-stage companies would hire a full-time in-house legal counsel. Similarly, fintechs can source compliance talent in creative ways. Options include outsourcing specific processes such as KYC, technology (i.e., regtech) to help automate processes, and bringing in senior licensed compliance professionals on a fractional or consultative basis.


Regulatory Notices and Actions: Looking Ahead to 2021 and Beyond

The general trend of regulatory notices and actions over the recent years shows increasing interest in fintech from regulators. The year ahead will amplify that trend. 

The more fintech moves from the leading edge to broader adoption, the greater the risk of trying to fly under the radar. In addition, as companies grow and mature, the more they need to consider additional types of clients and revenue streams.

While fintech’s wild-west days are already past us, the legacy of deciding to operate as an unregulated entity remains. The combination of greater risk and higher constraint must also become a thing of the past. Despite the initial challenges, getting smarter about regulation strategy will create much more growth opportunities as companies venture into the rest of this decade.

Would you like to learn more about Fintech Regulatory Trends?